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Why interest rates matter

Some context: I find that almost no one understands what interest rates are and what the Federal Reserve did last week when it “left rates unchanged.” But interest rates are important. Below is my brief, basic explanation of what interest rates are, what the Federal Reserve is doing when they set interest rates, and why timing interest rate hikes is a delicate task.

Interest is a price.

This isn’t a figure of speech. Interest is the literal price of borrowing money. It’s what we pay, in terms of future money, for the privilege of using someone else’s money in the present.

All prices, in turn, are informative. In fact, this is their essence: prices are a mechanism for communicating information about the world—specifically about how supply and demand conditions change. Friedrich Hayek explains:

We must look at the price system as such a mechanism for communicating information if we want to understand its real function … In abbreviated form, by a kind of symbol, only the most essential information is passed on and passed on only to those concerned. It is more than metaphor to describe the price system as a kind of machinery for registering change, or a system of telecommunications which enables individual producers to watch merely the movement of a few pointers, as an engineer might watch the hands of a few dials, in order to adjust their activities to changes of which they may never know more than is reflected in the price movement.

This information isn’t just incidental. It doesn’t just help “those concerned” find opportunities that otherwise would have simply gone unrealized. It’s vital to the successful functioning of business everywhere. It facilitates rational economic calculation and makes sustained profit possible.

Interest is a price, prices are information, and information is essential to the rational economic order. Clearly, the implications here are many. One in particular is of unique importance this year, as the Federal Reserve begins to tinker with interest rates after more than 80 months of near-zero rates following the financial crisis.

Now, I’ve been skeptical of talk that the Fed was ever serious about raising interest rates this year. I predicted in December 2014 that we’d see no rate hike in 2015, and I was almost correct (missed it by a month). But whether I was right or wrong doesn’t change how interest rate hikes (and cuts) affect economic activity. Whether the Fed does or does not raise rates doesn’t dampen the unprecedented risk the Fed takes by artificially manipulating interest rates in pursuit of even the noblest of goals.

We’ll start with premise #1: That the Fed manipulates interest in order to effect change in the economy. This is undisputed. Monetary policy actions (like manipulating interest rates) is the central bank’s tool to combat recession, and the only sphere over which it maintains an almost absolute controlling power. By lowering interest rates following the 2008 recession, the Fed sought to boost the availability of credit (that is, make borrowing money easier by lowering the price of borrowing money) in an otherwise recessionary environment which would likely have seen rates skyrocket. This would put downward pressure on things like business creation and investment, home and car ownership, etc.

Premise #2 is related: Interest rate manipulation has real effects on economic activity. If this weren’t the case, why would the Fed fix rates? By lowering interest rates, the Fed did stimulate lending and business activity that otherwise would not have happened. It staved off further liquidation by purchasing bad assets from banks, and infused confidence into markets that likely propped up things like household spending and borrowing, employment, and investment.

Conclusion: Mistiming an interest rate hike could have seriously traumatic implications for global economic health. If the Fed raises rates too soon (that is, before the “natural” rate has risen equivalently), it risks destabilizing an unrealized equilibrium and undoing what steps entrepreneurs have taken thus far to re-establish their economic footing. If it raises rates too late, it risks inflating a speculative bubble–the type that burst in 2008, after a quick rate hike followed by several years of low rates.

Now, whether it’s possible for the Fed to accurately time an interest rate hike is, itself, a worthwhile question…